The present mood in economic circles is one of cautious optimism. The feeling is that things can only improve from here as conditions cannot get worse. Growth is down and inflation sticky at a high level. Industry is at best crawling and there is little movement in terms of investment. Clearly the policy announcements have not yet had any effect, which is not surprising, given that they have not all been passed by Parliament; and even if they were, it would take time for money to flow in productive sectors.
We are happy that the Sensex is doing well and that foreigners continue to be interested despite our own apprehensions. Amidst these thought waves, the latest release of the Reserve Bank of India (RBI) on our external account is disturbing.
The current account deficit (CAD) for the second quarter (April-September) has turned out to be one of the highest ever at 5.4 percent of GDP. The prudent thumb rule is that anything above 4 percent is dangerous as it means that the country is earning fewer dollars than it is spending, which is not sustainable. We all knew that the deficit number would be higher than the last quarter’s 4.2 percent as the trade deficit has been widening and the denominator, the GDP, has been shrinking. But 5.4 percent is shocking, to say the least, as it actually means that our future is contingent on capital flows to sustain our external account.
These numbers are for the second quarter, and the trade numbers have not improved in the months of October and November. Export growth remains in the negative zone and the fall is sharper than in imports, where non-oil imports are negative, while oil import growth is positive. Quite clearly, the slowdown in the economy has affected the import of non-oil goods but oil imports continue to increase. And, more importantly, this has happened at a time when global crude oil prices are stable with a tendency to move down rather than up.
This means we are actually consuming more oil, which is not a good sign.
Is this alarming? Surely, it is, because 5.4 percent is scary. It could improve in the coming quarters, but will remain above 4 percent for sure and our hope that it would be around 3.7 percent can be ruled out as GDP growth is not going to change sharply to provide support. Is there need to panic? Definitely not, because we need to see if anything can be done about it, and more importantly, despite these negative developments, we have seen our external reserves quite stable during this time and the rupee has not really crashed - which should have been the case.
The answer lies in the capital flows which have, made up for this higher deficit through higher FDI and FII flows and some support from external borrowings.
The next question is what can policymakers do about the deteriorating current account? Given that most of the developments are exogenous, there is limited intervention that can be made. Export growth is more determined by demand than supply. The government has been on the right track for providing sops for exports, but they cease to help beyond a point. With a recession in the euro region and the US economy unsteady, we have to look at other emerging markets for support. But today, China too has slowed down while the other markets are unable to make up for the loss to other regions. Therefore, global dynamics will drive exports going forward.
Imports are critical and cannot be controlled. Non-oil imports are slowing down, ostensibly due to low demand for raw materials as well as capital goods as industrial production is low. Gold imports are still an issue and the government should look at making them more expensive as that seems to be the only way out given that we cannot revert to quantitative restrictions, which would create a black market. In fact, even higher duties may not necessarily help for the same reason. With oil imports also slipping way beyond tolerance levels, the trade deficit will continue to widen, pressuring the current account.
Two components of the current account in the past have provided succour to these flows- software receipts and personal transfers. These two flows have shown resilience in terms of maintaining their past levels or improving marginally, but given that they are dependent on developments in other countries, they cannot be relied on prop up the current account. Therefore, there is reason to believe that the current account will continue to be high and there is little that we can do.
But the situation is not as bad as it was in 1991 because the capital account can provide support here. There is a school of thought that says that we should not use capital account inflows to square the balance of payments. While this is true, as long as we get the mix right there would be less problems. FDI has been a good support these last few years and it is felt that the measures that could finally be passed by the government - on more FDI in retail, aviation, insurance, and pensions - would help to stabilise these flows in the next couple of years.
FIIs, or portfolio flows, are a debatable component. While it is considered to be hot money, our own experience has been that there have been only two occasions when they have withdrawn from the Indian market - during the Asian crisis of 1997 and the financial crisis of 2007-08. Therefore, while it is a theoretical possibility, it is unlikely that there will be large scale withdrawals as this would also mean an erosion in the value of their investments, if such a thing were to happen.
So what we have to do is get our policies right. We are providing more elbow-room to FIIs in the debt market - corporate bonds, infrastructure and government securities - which is pragmatic. We need to ensure that we do not do silly things like retro taxation or GAAR without thinking the measures through. Our balance of payments is clearly in the hands of foreigners today, given how things have turned out.
Counter-intuitive reasoning would say that in case we had not corrected our stance on these two after the budget, we would have been in a desperate situation today as deferment of these so called ‘bold measures’ did help to bring back the funds. This is not the best situation to be in, but frankly we have little options here.
The RBI has been liberal with external borrowings, which has helped bring in the dollars, but given that our external debt has risen alarmingly to $ 365 billion, we have to think hard on this one. As long as the RBI follows it stance on inflation, interest rates will be high, which in turn will induce corporates to borrow more through this route. But higher borrowings means more pressure on external debt, with the ratio of forex reserves to external debt coming down from 85.2 percent in March to 80.7 percent in September.
Where does all this leave us? The situation is distasteful, and even more so because we cannot do much here. The high number of 5.4 percent and the low probability of bringing this down to less than 4 percent provide more ammunition to the global rating agencies, which have been waiting to catch us on the wrong foot for some time now. High fiscal deficit, inflation, low growth and now wobbly external account could just give them reason to smile. We need to get our budget right next month and reverse the negative currents fast. Or else there could be trouble brewing.
The author is Chief Economist, Care Ratings. Views are personal.